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Seed Weekly - Tax Free Savings

In general, South Africans are not really good at saving. According to tradingeconomics.com personal savings in South Africa averaged R 1.2bn between 1960 and 2014 with a record low of –R 54bn in Q2 of 2014. See graph below:

To encourage South Africans to save more, Treasury announced that from 1 March 2015 all natural persons can save up to R 30 000 per year tax free.

The facts:
• You will be able to make investments into Tax Free savings accounts of R30 000 a year (R2 500 a month) and up to R500 000 over your lifetime.
• This will take approximately 16 years and 8 months to contribute the life time limit.
• For Treasury to ensure that investments are transparent the regulation stated that all fees must be reasonable and free of performance fees.
• There will be a limit for penalties on early withdrawals and no complex structured products are allowed.
• Your investment in this product will enjoy growth free of any tax on interest earned, tax on dividends paid out or any capital gains tax if applicable.
• You may withdraw your money at any time but whatever you withdraw you will not be allowed to be replaced, making it mostly suitable for long time saving.
• Only individuals can open an account, no account will be allowed to be opened for a company or a trust.
• Parents can open an account for their children as long as withdrawals are paid to that child, which makes this an attractive product for parents saving up for a child’s education.
• There are no limits to opening more than one account but a penalty tax of 40% will be implemented on the amount that exceeds the annual or lifetime contribution limit.

My initial thought was that it did not look like such a big saving and I wondered whether it was really ‘worth it’. To see if this held true I decided to do a simple comparison between investing in a discretionary investment (i.e. an investment where you are being taxed) vs the tax free savings account.

If we assume a personal marginal tax rate of 41%, the maximum contribution of R 2 500 per month, and an assumed return of 10% annually, the results are quite significant.

The investment return earned over the full period (16 years and 8 months) (net of tax) would be approximately R 1 495 000, compared to R 2 046 000 if a tax free savings account was used.

This amounts to a massive tax saving of R 551 000, with this difference growing the longer the investment in the tax free savings account is retained.

It can be safe to say that, just based on the above, it does make a lot of sense to make use of the tax free account. Add to it the flexibility of being able to withdraw at anytime – and also the fact that your money can grow faster compared to a regular savings account, I think it would be unwise to not make use of this.

At Seed we pride ourselves as being prudent stewards of wealth and our unit trust funds can now also be accessed via Tax Free Savings Accounts on the Momentum and Glacier platforms. For more information visit our website at www.seedinvestments.co.za or contact the office directly on 021 9144 966.

Seed Weekly - Property – Return Deconstruction

Many successful investors look to invest into assets that offer an attractive initial yield with a high probability of that yield growing consistently in real terms into perpetuity. By taking this approach, investors need not overly concern themselves with the prospects of capital growth, as the income generated (that should be consistently reinvested) will be a large component of the total return and, as with most investments, capital growth should approximate income growth over a full cycle. Furthermore, if investing when the yield is higher than the long term average, investors could receive additional capital returns through the rerating of the asset.

When looking at the local listed property market, it is interesting to dissect the three sources of return to determine whether this asset class offers value or not. Property is an asset class that local asset managers have (even in their own words) historically been underweight, and it is interesting that there are currently divergent views about this asset class amongst some of the larger managers.

The starting yield offered by this asset class is currently 5.3%, which is at the low end when compared to its history. This is partially offset by ultra low interest and inflation rates which have resulted in most other asset classes also offering historically low yields. While the market trades at historically low rates, property portfolios can be constructed with an initial yield of between 6.7% - 7.7% (above cash and broadly in line with bonds).

While it’s all good and well to construct a portfolio with a high starting yield, it is short sighted if this is done at the expense of yield growth. The above mentioned portfolios have expected annual distribution growth over the next three years of between 8.5% and 10.5%, which in the current low inflation environment is healthy real growth. These expected numbers aren’t much different from the historical real growth in yield generated by property. The chart below shows real distribution growth of the index over the past 10 years. Over this period property distributions have grown, on average, 2% pa ahead of inflation (in line with the often quoted 8% annual rental escalation clauses many tenants face). Even from their peak (in mid 2007) distributions have grown in line with inflation.

Naturally there are risks that real distribution growth will temporarily go negative, which is where active management will play an important role. Over time, however, we remain convinced that the industry as a whole can grow distributions in line with inflation, with the better operators growing income in real terms. We also think that investors under appreciate (and hence undervalue) the consistency of this distribution growth (over this period annual equity distributions have twice contracted by more than 10% in nominal terms).

Over the very long term the impact of the change in rating doesn’t have too much of an effect on the total return generated from an investment (unless investing at valuation extremes). It does, however, add to the volatility of the return over the shorter period and is often a reason used by investors not to invest into property. This is the case as the initial yield has a high correlation with the bond yield, but what investors often fail to appreciate is the consistent growth in yield from property that is nonexistent in bonds. We also don’t define risk as volatility, but rather the permanent destruction of capital.

Seed’s Multi Asset Funds (Seed Flexible Fund and Seed Absolute Return Fund) and other managed solutions have performed extremely well over the past few years on a back of a sizeable allocation to property. While we aren’t married to this investment view, we expect that property will continue to deliver solid mid to upper single digit real returns for the foreseeable future (although it may exhibit a fair amount of volatility on the way).

Seed Weekly - AVI – Growing Great Brands

AVI Ltd is listed on the JSE under the Food Producers sector, and the company is involved in the manufacturing, processing, marketing and distribution of branded consumer products.

AVI houses many of South Africa’s favourite brands across several market sectors, including beverages (Five Roses, Koffiehuis), biscuits & snacks (Bakers, Willards, Provita), fashion & beauty (Yardley, Lenthéric, Coty) and frozen foods (I&J). The brand portfolio includes 33 owned brands and 20 international brands under license, with brands targeting consumers across all income groups. AVI’s competitors include Tiger Brands, which is double the size by market capitalisation, and Pioneer Foods, which is roughly the same size.

History

AVI was formed in 1944 when the Anglovaal group split its interests into three segments - engineering services (Aveng), Mining (Avmin) and consumer products (AVI). The industrial assets were unbundled into two new listings, Aveng and AVI, in 1999.

Latest Results

AVI recently released its interim results for the six months ended 31 December 2014, and management believes decent results were achieved given a challenging trading environment.

Revenue increased by 11.1% to R6bn on the back of higher selling prices, while cash from operations was up 16% to R1.31bn. Headline EPS increased by 10%, as did the interim dividend. A special dividend of R2 per share was declared, “in line with AVI’s ongoing commitment to return excess cash to shareholders.”

Operating profit was up 13% to R1.15bn from the previous reporting period. Operating profit has grown at 17% per year over the last 10 years, while the operating profit margin increased from 10% in 2005 to 19.2% currently.

The biggest contributors to operating profit were Entyce (beverages) and Snackworks (biscuits & snacks), which benefitted from both higher selling prices and volume growth.
I&J reported higher catch rates and sales volumes, while the weaker rand materially increased income from exports. A fuel price hedge that was marked-to-market partially offset some of I&J’s contribution to operating profit.

Spitz – a quality footwear retailer – reported record sales in December and only had limited impact on sales from load shedding.

Green Cross was a significant detractor, with volumes declining and shelf space lost to competitors. In addition, six retail stores had to be refurbished.

AVI’s gross profit margin improved slightly from 44.3% to 44.5%, with international fashion brands negatively impacted by a weaker rand, but food and beverage brands benefitting from price increases.

Outlook and Fundamentals

Overall, management expects the current constrained consumer demand environment to persist. The I&J business segment provides a nice hedge against rand weakness, as higher import costs for the international fashion brands will be partially offset by higher I&J exports.

The beverage and snack segments are well established, and should be able to defend their market share and profit margins. Green Cross should hopefully benefit from the store refurbishments and raise volumes accordingly, given that retail space has also grown.
I&J has locked in most of its exchange rates for the second half of the year, and should benefit from lower fuel prices. Maintaining high catch rates is crucial to this segment having a strong second half.

AVI’s dividend yield of 3.2% compares well with its peers Tiger Brands (2.4%) and Pioneer Foods (1.1%). Currently trading at a PE of 21, AVI is more expensive than Tiger Brands (19) but significantly cheaper than Pioneer Foods (30) on this basis.

AVI is included in the Seed Equity Fund at a 1% weight, with strong recent price and earnings momentum securing it a place in the Momentum portfolio.

Seed Weekly - Investment Greats: Jack Bogle

John Clifton “Jack” Bogle is most famous for creating the world very first index fund – the Vanguard 500 in 1976. Bogle founded The Vanguard Group in 1974 which currently operates as one of the world’s largest mutual fund and Exchange Traded Fund (ETF) providers.

Jack Bogle, currently 85, graduated with a cum laude degree in economics from Princeton University in 1951. He studied mutual funds in depth during his university days, which grew into his senior-year economics thesis which laid the conceptual groundwork for the index mutual fund. He started working for an advisory business, climbing the ranks up to chairman. In 1974 he was fired for an “extremely unwise” merger decision he approved. "The great thing about that mistake, which was shameful and inexcusable and a reflection of immaturity and confidence beyond what the facts justified, was that I learned a lot." He started Vanguard that same year.

It's nearly 40 years since Bogle pushed long and hard to get Vanguard to introduce the first low-cost index mutual fund. At the time, some people dubbed it Bogle’s Folly. Now, there's almost $2 trillion invested in U.S. index-based funds and exchange traded funds.

Bogle pioneered the no-load mutual fund and low-cost index investing for millions of investors. Known for putting the interest of the investor first, he has constructively criticized the US fund management industry for charging too high fees.

His investment style is simple - capture market returns by investing in broad-based index mutual funds that are characterized as no-load, low-cost, low-turnover and passively managed. He is famous for his insistence, in numerous media appearances and in writing, on the superiority of index funds over traditional actively managed mutual funds.

He contends that it is folly to attempt to pick actively managed mutual funds and expect their performance to beat a low-cost index fund over a long period of time, after accounting for the fees that actively managed funds charge. Bogle argues for an approach to investing defined by simplicity and common sense. Below are his eight basic rules for investors:

In a recent interview he mentions that one primal role of one’s financial adviser should be to keep the investor from making bad decision. "If you have trouble imaging a 20% loss in the stock market, you shouldn't be in stocks." "When reward is at its pinnacle, risk is near at hand."

Again it comes down to keeping your investments strategy simple, minimize costs, invest for the long term and make rational (not emotional) decisions. "Time is your friend; impulse is your enemy.”

Jack Bogel is the author of a few investment related books, his most famous being the bestselling Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor (1999) which is considered an investment classic. Bogle retired in 1999 from the Vanguard group but continues as president of Vanguard's Bogle Financial Markets Research Centre to write and lecture on investment issues and is widely recognized as "the conscience" of the mutual fund industry.

Even Warren Buffett recommended Vanguard for his estate, in his 2013 letter to shareholders: My advice to the trustee couldn't be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.

Seed Weekly - Income Tax

Last week, the South Africa Minister of Finance tabled the government budget in parliament. This process actually provides a very detailed look into government finances. Naturally of most interest are some of the specific changes to the tax act that will affect both individual and corporate taxpayers. In Western democracies we have become so accustomed to high rates of tax on both the corporate and individual level, that we think that this has always been the norm in society.

Yes, the concept of a tax has been around for much of civilisation and, in the case of the Roman Empire, consisted of a modest percentage levied against wealth in the form of land, homes, slaves etc. Rome also collected customs duties on imports and exports as well as a form of sales tax.

But in many ways the concept of an income tax as we understand it is a relatively modern concept – modern in that it has been around since approximately 1800 in Great Britain, introduced to pay for weapons and equipment for the French Revolutionary War. A tax on income does presuppose that there is a common understanding and recording of receipts and expenses, accurate recording of profits and reliable records etc.

In the US the first income tax was suggested during the war of 1812 but was never inaugurated. Then the Tax Act of 1862 was passed with rates of 3% on income above $600 and 5% on income above $10 000. It was primarily to finance the Civil War and while the population accepted the tax imposed, compliance was not very high at all.

In the US, this Act was repealed in 1872 and in 1913 an amendment was passed, which allowed Congress authority to tax US citizens on income from whatever source derived. Over the years the tax act has become progressively more complicated.

In South Africa, income tax was first introduced in 1914. The tax Act was updated again in 1962 and from that stage has gone through numerous updates and amendments. It is known as a progressive income tax system in that the higher the earnings, the higher the rate of tax. In the latest budget announcement the top tax rate was increased from 40% to 41%.

In the latest budget for the year ahead, government is looking to bring in tax revenue of just shy of R1,2 trillion, up from R1,1 trillion. The three biggest components of this revenue are individual tax at 36%, VAT at 26% and corporate tax at 19%. The main sources of tax revenue are reflected in the table below.

Expenditure is budgeted to come in at R1,35 trillion, leaving a budget deficit of R162 billion which will need to be financed through the raising of fresh government debt.

The country’s gross domestic product (GDP) is expected to be in the region of R4,2 trillion and so revenue as a percentage of GDP comes in at 28,4%, while expenditure comes in at a massive 32,2%. The budgeted deficit as a percentage of GDP is a number that is followed closely. This is now budgeted to come in at 3,9%.

As the government’s debt burden increases, so does the interest component in servicing this debt, which in itself is a large component of expenditure. The interest bill was R121 billion in last financial year and in three years’ time is expected to grow to R158 billion and average 3,2% of GDP.

However, because of the threat of an investment downgrade, despite increasing in absolute terms, debt as a percentage of GDP has been revised downwards from the projection in the medium term budget policy statement in October 2014. Total gross loan debt as a percentage of GDP is expected to rise to 46% now to 47,6% in three years’ time.

There is little argument that the South African government has little wriggle room when it comes to increasing government expenditure, raising meaningful levels of new taxes and increasing its debt levels, without having an adverse consequence. Just like any business or household that has a tight budget and high levels of debt – i.e. higher than annual revenue – it has no choice but to continue to look for ways to increase its revenue. But probably of greater importance is to look for ways to ensure greater efficiency in expenditure. This is going to be the real challenge in the years ahead.